FM Commentary

Global Housing Bubbles

The housing bubbles of the 2000's were not a “Made in America” phenomenon. As Professors Carmen Reinhart and Kenneth Rogoff showed in their definitive book on the history of financial crises, many countries “had their own homegrown real estate bubbles” in the last decade.1

This is made clear in Exhibit 1, which is a pairwise comparison of increases in house prices (after inflation) in the U.S. and 20 other advanced industrial countries using data from the Organization for Economic Co-operation and Development (OECD). In 14 or so of the 20 comparisons, the U.S. was a laggard, bubble-wise.

Exhibit 1: Cumulative Change in Real Home Prices Since 19972

This pattern is further clarified in Exhibit 2, which summarizes the data in Exhibit 1. It shows the maximum absolute (i.e., positive or negative) change in real house prices from the first quarter of 1997 through the third quarter of 2011 and indicates the quarter in which the maximum was reached. Again, the U.S. is fifteenth in a list of 21 countries with a 58 percent increase in real house prices between the first quarter of 1997 and the fourth quarter of 2006.3 In fact, there are only two countries (Italy and Switzerland) below the United States before there is a negative change in real house prices.

Exhibit 2: Maximum Absolute Cumulative Change in Real House Prices Since 1997 (with the year and quarter in which the maximum was reached)

Of the four countries on the right of Exhibit 2 (where prices have fallen more than they have risen since 1997), the OECD gives a longer time series for Germany and Japan than that depicted in Exhibit 1. These are compared with the United States from 1985 to the present in Exhibit 3. Japan, in particular, had its own house-price bubble which peaked, in real terms, at 36 percent above the level of Q1 1985 in the first quarter of 1991. Since then, prices have had a long decline, with real home prices still at 26 percent below the peak of 20 years go. This experience mirrors, of course, very difficult conditions in the Japanese economy generally.

Exhibit 3: Real House Prices in Germany, Japan, and the U.S., Q1 1985 – Q3 2011(with the year and quarter in which the maximum was reached)

One of the advantages that the U.S. has going for it is that its territory is large and its economy diverse. As a result, there is a certain amount of diversification in home-price patterns across the country – some areas experienced more of a bubble, others less. On the bubble side, the Federal Deposit Insurance Corporation has called the experience in California, Florida, Arizona, and Nevada – labeled the “Sand States” for their beaches and deserts – a “Perfect Housing-Market Storm.”4

Exhibit 4 slots these states into the international analysis in Exhibit 2 above using the same FHFA House Price Index and the same deflator for the states as the OECD uses for the country as a unit.5 The house-price increases in the Sand States are indeed more extreme than in the United States as a whole and California comes closely behind Ireland in terms of real house-price increases. The three other Sand States, however, are not exceptional compared to the countries covered by the OECD data and stand behind such notable nations as the UK, Australia, Spain, and France, and just ahead of Denmark, which is sometimes put forth as an exemplar of a housing finance system that could be applied in the U.S. In the main, in other words, most of the extreme examples of the housing bubble in the United States are in the middle of the pack internationally.

Elevated house-price appreciation might not be regarded as a bubble if it was supported by fundamentals. For instance, if the income of the typical family had risen commensurately with home prices, affordability would not be affected.6 It is common to compare house prices to income to judge whether bubble conditions exist.

This comparison is made in Exhibit 5. While the details have changed, the procedure has essentially no impact on the qualitative results in Exhibit 1 above. The United States is now sixth from the bottom, more or less where it was before. The results should not be surprising. In a period with rapidly increasing nominal house prices, deflating the results using an income deflator instead of a consumption deflator is not likely to make a huge difference.7 The same general results hold if we use a price-to-rent ratio instead of a price-to-income ratio.8

Exhibit 5: Index of House Prices Deflated by Per Capita Income, 1997-20119

Exhibit 6: Maximum Absolute Cumulative Change in House Prices since 1997 Deflated by Per Capita Income (with the year and quarter in which the maximum was reached)

Exhibit 7 repeats the exercise of Exhibit 4 by slotting in the Sand State house price data (deflated by per capita disposable personal income) into the international comparison.10 The general picture remains more or less as before except for the most noticeable fact that California moves into first place. In other words, if California were a country, its house price inflation would have outstripped the income of its residents to a larger extent than any of the countries in the OECD database.11, 12

But, of course, the essential point is that California is not a separate country. The country of which it is a part is located to the right rather than the left of the distribution in Exhibit 7. Even though California’s standalone economy is larger than most of the countries in the chart,13 it is distinctly different from them in the fact the state is part (12 percent by population, 13 percent by GDP) of a much larger economic, monetary, and fiscal union. In contrast: “Looking back at the causes of the debt crisis in Europe, we conclude that incomplete economic, financial, and fiscal integration is part of the answer.”14

A housing bubble and subsequent decline in prices was followed by (and, in many cases, caused) severe banking/financial crises and deep recessions in a considerable number of advanced economies. In a recent report, the OECD charted the direct fiscal costs to governments of recent financial crises (Exhibit 8). This is a narrow reckoning of the costs of the crises since it only tallies the direct costs to governments. Also, the countries listed are not the same as those for which we have house-price data. Nonetheless, the relative position of the United States is similar to what we have seen in the earlier charts – to the right of the distribution.15 An earlier paper from the IMF looked at broader measures of the cost of the crisis (increase in public debt and loss of economic output) in 23 countries.16 It showed again that the U.S. was unexceptional.

Exhibit 8: Fiscal Cost of Banking Crises (as Percent of GDP)17

Since the housing bubbles and financial crises were a global phenomenon, it is important to consider systemic shared causes and/or memes18 as an explanation, rather than remain focused on local institutional arrangements. Systemic causes could include global trade imbalances, ultra-low interest rates, stagnant wages, or a savings glut in some areas of the world feeding increased household debt burdens in others. Peripatetic memes could include a belief in light-touch financial regulation, relaxed underwriting standards, or the pernicious idea derisively captured in the title of the aforementioned Reinhart and Rogoff book that “This Time is Different.”19 Based on these data, entities (such as Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and Ginnie Mae) and legislation or regulations (such as the Community Reinvestment Act) that are unique to the U.S. housing finance system do not seem to work as explanatory variables for the occurrence of these global developments.20

Noel FaheyDirector, Economics and Strategic Research

1 Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009, page 244.2 Source: OECD. Countries are arranged in pairwise comparisons with the United States. They are ordered by the maximum cumulative increase in real home prices since 1997. Thus, Ireland experienced the largest price increase (of 177% between Q1 1997 and Q1 2007) and is shown in the first chart..3 The OECD uses the House Price Index computed and published by the Federal Housing Finance Agency. The index is “a weighted, repeat-sales index, meaning that it measures average price changes in repeat sales or refinancings on the same properties.” (See http://www.fhfa.gov/Default.aspx?Page=81) 4http://www.fdic.gov/bank/analytical/quarterly/2009_vol3_1/AnatomyPerfectHousing.html. 5 To avoid unnecessary clutter in the chart, the four countries with negative numbers in Exhibit 2 are excluded in Exhibit 4.6 Since most houses are purchased on credit, falling interest rates could also maintain affordability in a rising house-price environment (as happened in the U.S., for instance, roughly between 1998 and 2003). Of course, low interest rates may not be permanent – and rising rates could reverse the affordability boost of the lower rates.7 What is different when the house prices are deflated by income is that prices in the U.S., as measured by the FHFA House Price Index, are back to where they were pre-bubble in 1997. This is more than can be said for many other countries (such as the UK, Australia, Sweden, Norway, Spain, France, Denmark, Belgium, Greece, Canada, the Netherlands and Italy). In theory, this should be a positive development in the United States since it could signal that the excesses of the housing bubble have finally been wrung out of the market. However, any optimism has to be tempered by several facts such as the intervening damage caused by the boom and bust in house prices and the uneven distribution geographically of house prices and individually of income. 8 The Economist magazine points out that “the price-to-rent ratio … is a bit like the price-to-earnings ratio used to value companies. Just as the value of a share should reflect future profits that a company is expected to earn, house prices should reflect the expected benefits from home ownership: namely the rents earned by property investors (or those saved by owner-occupiers).” (http://www.economist.com/node/21540231) 9 Nominal house price divided by nominal per capita disposable income. The country ordering in Exhibit 5 is the same as in Exhibit 1.10 Source for state disposable per capita personal income: http://www.bea.gov/histdata/RMyearAPFfiles.asp?docDir=/2009/PI/state/revised_September-20-2010. Quarterly data are estimated by linear interpolation between the annual figures from the Bureau of Economic Analysis.11 Too much should not be made about the exact placement of states and countries in these comparisons. Measurement of house prices internationally is a notoriously inexact process and there is considerable variability in the techniques used and the properties covered across countries. Additionally, the measurement period chosen can also impact rankings. In the comparisons above, 1997 was used as the starting date governed by both the availability of OECD data and the general impression that 1997 was the approximate start of the bubble period in many countries. A different starting date could (and probably would) result in different rankings.12 California switched place with Ireland between Exhibit 4 and Exhibit 7 because the deflator used, nominal per capita personal income increased more rapidly (at an annual rate 6.5%) in Ireland during the Celtic Tiger period when house prices were growing to their maximum (from Q1 1997 through Q1 2007) as against 4.6% for California during its bubble period (from Q1 1997 through Q1 2006).13 California’s GDP was roughly the same as Italy’s in 2010. It was outstripped only by Japan, Germany, the UK and France among the countries examined in this piece. (See http://www.bea.gov/newsreleases/regional/gdp_state/2011/gsp0611.htm and http://stats.oecd.org/Index.aspx?DatasetCode=SNA_TABLE1) 14http://www.imf.org/external/pubs/ft/fandd/2011/09/PDF/allard.pdf. 15 The U.S. is listed twice in Exhibit 8. The listing for 1988 is for the cost of cleaning up failed S&Ls. 16 Luc Laeven and Fabian Valencia, Resolution of Banking Crises: The Good, the Bad, and the Ugly, IMF, June 2010, Figures 10 and 12 (http://www.imf.org/external/pubs/ft/wp/2010/wp10146.pdf) 17 Dates refer to year in which the banking crisis started. Gross fiscal costs (excluding recovery proceeds) are computed over the first five years following the start of the crisis. Gross fiscal costs include bank recapitalization and asset purchases. It excludes asset guarantees – although according to an earlier IMF paper (http://www.imf.org/external/pubs/ft/wp/2010/wp10146.pdf, Table A.3), the inclusion of asset guarantees would represent a significant increase in the cost only in the cases of Belgium, the Netherlands and the UK among the countries listed in Exhibit 8. Unfamiliar country codes: ISL = Iceland; NLD = Netherlands; HUN = Hungary; LUX = Luxembourg; CZE = Czech Republic; ESP = Spain; BEL = Belgium; AUT = Austria; GRC = Greece; DNK = Denmark. Source: OECD (http://www.oecd.org/dataoecd/8/17/48861848.pdf, Figure 6B). 18 The term meme was coined by the British evolutionary biologist Richard Dawkins (See: Richard Dawkins, The Selfish Gene, 1976, page 192). It rhymes with scream. A meme is contrasted with a gene in the physical world – it acts as a vehicle for transmitting ideas or practices, which can be transmitted by imitation rather than reproduced genetically. Also corresponding to the gene pool, the meme pool is humanity’s collection of such ideas. 19 See endnote 1 above. “We hope the weight of evidence in this book will give future policy makers and investors a bit more pause before next they declare, ‘This time is different.’ It almost never is.” (page xxxv) 20 See Robert Avery and Kenneth Brevoort, 2011, pages 33-41 for an examination of the role (or lack thereof) of the GSEs and CRA in the housing bubble (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401). See also, The Subprime Crisis: Is Government Housing Policy to Blame?, Federal Reserve Board, 2011, (http://www.federalreserve.gov/pubs/feds/2011/201136/201136pap.pdf).